Due Diligence in China: Revealing the Dark Side of the Moon

American companies often feel "the need for speed." In a business world where Internet time has become the norm, the watchword is: get the deal done.

The race to close new ventures over seas doesn't always leave room for effective due diligence. After all, the theory goes, we do these kinds of deals every day. But U.S. businesses accustomed to cookie-cutter deals in other jurisdictions – or even in sophisticated business markets like Europe – often underestimate the perils of the murky, high risk/high reward marketplace in China. This is a region where it pays to do your homework.

The Appeal of the Market
It's easy to understand the lure of the Chinese market.

While the early failures and unmet financial expectations of certain multinationals operating in China are well known, the number of success stories in China is increasing, as foreign companies learn from their early mistakes and garner the economies of scale resulting from their early investments. China's growing market liberalization (including the country's pending accession to the World Trade Organization) also promises a smoother road for foreign companies looking to build and sustain profitable operations there.

For those with a long-term commitment to the market, there are good reasons for doing business in China:

1. A rapidly expanding middle class of consumers;
2. Low-cost, high volume and skilled manufacturing capabilities;
3. Strategic advantages offered by efficient just-in-time operations that can supply goods to customers within China, regionally and internationally;
4. Local content to satisfy the demands of customers or downstream suppliers; and
5. A leg up in the race to beat competitors in establishing strategic operations.

It is often this last factor – the race to get ahead – that contributes most significantly to poorly structured, inadequately approved and ultimately failed investments in China. For all its opportunities, the Chinese market carries risks that are unique to the world's emerging economies. While foreign companies may recognize the need for enhanced due diligence in China, many don't always appreciate the cultural and business impediments in China that make the due diligence process especially challenging.

An Ounce of Prevention
Making your investment and contractual relationships prosper means minimizing risks. But identifying business and regulatory risks in China, for those unfamiliar with the process, may sometimes seem like trying to focus a telescope on the dark side of the moon. There is also a tendency to allow willful blindness to take hold, as if what you don't know can't hurt you.

In China, many foreign businesspeople have unspecified fears and suspicions about their prospective acquisition targets, joint venture partners, agents or suppliers. However, they often hesitate to probe for more information, wondering if they really want to know the truth. But the experience of those long familiar with China dictates that you must ask the tough questions early in your process if you wish to avoid costly and disruptive surprises that will emerge from otherwise unknown and unaddressed problems.

Corruption, incompetence, hidden liabilities, sloppy commercial practices and self-dealing are regrettable legacies of a centrally controlled economy where lethargic, state-owned enterprises were often populated by under-worked managers and laborers. Foreign companies are wise to look beyond the formal exchange of information in tightly controlled negotiations and goodwill banquets to assure that their investment will not be put at risk by vestiges from China's recent economic past.

Acquisitions and Joint Ventures
The litany of due diligence information needed in a joint venture transaction or acquisition is so fact-specific, and extensive, that including detailed suggestions for those undertakings is well beyond the scope of this article. However, some basic guidelines may be helpful.

Most Chinese companies regard the information typically sought by foreign parties in due diligence investigations as internal company "secrets." Indeed, those companies may have good reasons for protecting such information. It is not uncommon for domestic Chinese companies to keep two sets of books—one for the tax authorities and one for the industry agency to which the company is responsible.

As a result, the initial reaction of the Chinese party to due diligence requests is often resistance and disbelief (actual or feigned). Explaining the process and offering reciprocal investigation opportunities to the Chinese party, when appropriate, will help defuse some of the concern. Most Chinese companies will not appreciate or want to invest in a similar due diligence process, but the offer and appearance of reciprocity will be meaningful. It will demonstrate a desire to maintain the well-established Chinese business precepts of "equality and mutual benefit."

Long after explaining and obtaining a general consent to conduct due diligence, expect haggling over the scope and detail of the investigation. While asking for too much information upfront can so overwhelm the Chinese party as to discourage it from even considering the process, it helps to build in some room for making concessions. And remember that the process will take time: simply negotiating the scope of due diligence in complex transactions may take a month or two.

Once agreement is reached on the areas or inquiry and the means for obtaining the requested information, be prepared for your patience and persistence to be tested. Promises of documents will long go unfulfilled; lawyers and accountants will be told that "the man with the key isn't here"; and particularly sensitive questions will be deferred to a senior manager, or even the head of the company. These are all effective forms of passive resistance that can, and often do, wear down foreign investors.

How you should respond depends on the practical realities of the deal. Do you have materially what you need, or is the outstanding information critical to the terms of the transaction or your willingness to proceed? Our experience suggests that polite perseverance is the best way to get results – including making clear that closing the transaction depends upon the Chinese party's satisfactory completion of the due diligence process. For especially sensitive matters, third party private investigators, such as Kroll or Pinkerton, can provide additional helpful information that is otherwise difficult to obtain.

Non-investment Contractual Relationships
Direct foreign investment scenarios are by no means the only occasions that warrant due diligence investigations in China, however. Here are some additional scenarios.

Contract Manufacturers
It's a natural first question to ask, "How cheaply can they make it?" But satisfying a U.S. company's standards for human rights, ethics, and quality often means further investigation beyond price. The following areas of initial inquiry are relevant to a "soft" due diligence investigation of a potential supplier in China:
Company's full legal name; date and jurisdiction of establishment.

• What is the corporate structure of the company? Is it a private or state-owned company? Who are its key officers, shareholders and subsidiaries?
• What are the background and current activities of the company?
• What is the reputation of the company in its industry? What do competitors and trade organizations say about it?
• What is the company's reputation with suppliers, other customers and employees?
• What is the current status of similar business undertakings in which it is involved?
• What is the background of the management?
• What are the character, integrity and reputation of its key managers, owners and officers? What are its practices with respect to "commissions" paid to agents, including to buyers' representatives?
• Does the company have a history of labor troubles, strikes and disputes?
• Does the company comply properly with required ethical and social standards? For example, has it ever employed child labor? Do the workers get adequate time off, overtime pay, and mandatory benefits?
• What level of political support does the company enjoy locally?
• Has the company ever been involved in any legal disputes?
• Has it ever run into trouble with regulators? What do local regulators think of this company?
• Does it comply with environmental rules? Is it at risk for future prosecution for environmental pollution?

Commercial Agents
Using commercial agents to source business, and paying them a commission based on their results, is a common practice, but is also rife with ethical risks in China. Establishing the wrong business relationships can do permanent damage to a foreign company's reputation in the country and possibly violate U.S. laws prohibiting certain corporate practices. The risks are particularly high if you are pursuing government contracts or if governmental agencies are involved in your potential transaction.

Here is some of the general information you will want to obtain regarding a prospective foreign business agent:

(1) General information about the agent company:

• full legal name
• date and jurisdiction of organization
• addresses of headquarters, branch offices and other facilities
• names of managers, officers and directors
• identity of immediate and ultimate owners
• names of affiliated businesses and relationship to them
• organizational structure, manpower resources, technical staff and their expertise
• similar matters on which the company has worked in the past
• field experience the company has in providing after-market services of the sort required (if applicable)
• total annual sales in U.S. dollars
• information regarding the company's past and present clients and its general reputation in relevant business circles
• references to other companies with which the company has done business, especially those in the U.S.

Information on the company's relationship with the PRC Government

• past experience and present commitments of the company or its affiliates with governmental agencies or state-owned companies
• does any principal or employee of the company hold a full-time or part-time position with the Chinese government or with any Chinese political party or state-owned company?

The nature of proposed relationship with the company

• How do the proposed terms of the agency arrangement with the company compare to arrangements used by others in China or the industry in similar situations?
• Are you aware of any laws, regulations or policies in China which might prohibit, restrict or otherwise affect the terms of the proposed arrangement? For example: 
• Are there registration or notification requirements for the agreement to be valid?
• Are there laws in China to which the company and its principals are subject, which restrict the amount of payments to the company or the method of payment of fees or commissions?

What are the real risks of faulty due diligence? In China, promising business ventures may fail as a result of unknown corruption, management incompetence, personnel clashes and liabilities. The result: additional legal and accounting fees and a major business disruption.

Solving problems after the fact will usually cost much more than a prudent and focused due diligence investigation undertaken at the outset. Resist artificially-imposed timelines to close your transaction. Maintain your commitment in China to the sound business practices that have enabled you to prosper elsewhere and, with appropriate market and cultural adjustments, you will be positioned to succeed in China as well.